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Wednesday, February 14, 2018

The correction is here. What next?

In our last post we mentioned how the 3 major US equity indices all broke their steep rising trend-line from the January lows. In turn, we expected volatility to pick up. Well that was certainly an understatement. Volatility went ballistic and the equity markets had the long overdue intermediate correction that so many investors have been waiting for. What seemed to spook most traders was the speed and violence of the correction. The S&P had a close to 12% correction from peak to through in just 10 trading days from all time highs in January. While the velocity of the pullback was shocking to most there is precedence as history shows. The flash crash in May of 2010 had a 2-week decline of 12.5% straight off highs. Going back to the 1950's the current 2-week loss ranks only 49th, while most of the bigger losses were during bear markets there were plenty during bull phases. During the bull market in the late 90's 1996, 1997 and 98 had similar 2 week plunges off highs. The recent move has been compared to the 1987 crash but there was a more analogous move in September of 1986. The question we are pondering: is this an intermediate correction within an ongoing bull market or the start of a prolonged correction/bear market? Ultimately we don't know the answer. However, we use all the data we monitor and make an educated bet. If we are wrong in our market call we utilize risk management to keep losses to a minimum.

2018

1996-1998

1986-1987

Below if we look at breadth in the form of % of stocks trading above the 50 day moving average we can see that during the current correction, breadth has hit extreme levels associated with prior drops. The good news is when you get a wash out in breadth, historically you are closer to finding a low. Did the market find a low last Friday or are we subject to a retest? Again we don't know the answer to that question. Urban Carmel over at the Fat Pitch Blog tried to answer this question in his latest post. In our own experience, after you get a quick trend reversing move, it typically takes a few weeks for the ultimate low to be established. What we are looking for is the potential for a positive divergence setting up as the market tries to stabilize after the current shock. This will take shape in breadth improving as price probes lows. Our best guess is the general market will need more time to digest the violent pullback we just experienced.

Below are some stats on corrections and bear markets to keep the current move in perspective. According to Goldman Sachs the average bull market correction is 13% over four months an takes just four months to recover versus and average decline of 30% during bear markets.

One of best ways to get a read on the macro environment and sentiment is the monthly fund manager survey from BAML. Below are the key takeaways from the February report.

Best contrarian trade: long Utilities, short Banks (68% hit ratio when FMS bank-utilitysentiment this stretched).

One of the main culprits of the recent market weakness was the blow up of the short volatility trade. This is just another reason why we prefer tactical exposure and practice active risk management. Below is the chart of the XIV etf. It lost more than 90% of its value overnight as they bet on volatility remaining quiet. This strategy posted remarkable returns over the last few years until it was all over in 1 day on the heels of the VIX having its biggest one day move ever. As of last months survey this was the most crowded trade and caught many funds holding the bag. FMS cash rose to 4.7% moving the FMS cash rule back into a contrarian
"buy" signal. My guess is this number will increase next month also.
Meanwhile there was a big rotation into cash in February as investors
were reducing risk. Outside of volatility, the biggest tail risk remains inflation and a bond crash. The move in yields has the attention of most traders and one of the bigger reasons this market remains on edge. The current allocations confirms the jitters as cash climbed to net 38% overweight which is the highest since Nov of 2016. At the same time, allocation to bonds is now at a record low net 69% underweight and equities fell to 43% overweight which is the largest one month fall since Feb of 2016. On a positive note investor expectations for above-trend growth and above-trend inflation hit their highest since April 2011, overtaking below-trend growth and below-trend inflation for the first time in seven years.

In summary, the market got a 5 and 10% correction all in the span of 10 days after breaking records for the longest streak without such pullbacks. Based on our last post the fundamentals remain bullish and the current correction hasn't changed that. We will be watching yields and how they play out over the next few months but with allocations at all time lows to bonds, we think the contrarian position might be the best play in the short term. Our thesis on the continuing bull market remains intact and we think pullbacks should be looked at as opportunities instead of panicking. With that said, from a tactical angle the next few weeks or months could contain bouts of heightened volatility and choppy market action. We plan to keep some powder dry while taking smaller position sizes looking for opportunities to exploit as the market digests the current action and tries to resume the longer term up trend.

Ryan Worch is the Managing Director of Worch Capital LLC. Worch Capital LLC is the general partner of a long/short equity strategy that operates with a directional bias and while emphasizing capital preservation at all times.

About Me - Ryan Worch (Virginia Tech Grad)

Ryan Worch (Graduate of Virginia Tech - Pamplin College of Business) began his career in finance in 1999 at Newby & Company as an assistant trader and broker. Mr. Worch is a registered investment advisor in the state of Maryland. Mr. Worch graduated with a Bachelor of Science in Business from Virginia Tech in May 1999, where he majored in Finance.

Prior to starting Worch Capital, Ryan worked for Metzman Capital Ventures. He held various positions working his way up to portfolio manager. He managed an in house portfolio utilizing a growth strategy.

Ryan Worch (Virginia Tech) founded Worch Capital in 2006 where he currently focuses all of his attention. Worch Capital specializes in the management of enhanced equity and alternative investment products.
Worch Capital, LLC (“the firm”) is a Registered Investment Advisor
based in Bethesda, MD. The firm also serves as the General Partner of a
long/short equity strategy.

Ryan is married to a wonderful wife and has four amazing children. Outside of the office Ryan is an avid sports fan and enjoys playing golf anytime he can sneak away.

Disclaimer

Please see disclaimer tab for additional language. This material is provided for informational purposes only, as of the date hereof, and is subject to change without notice. This material may not be suitable for all investors and is not intended to be an offer, or the solicitation of any offer, to buy or sell and securities.